ECONOMIC FLUCTUATIONS

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PART 5
ECONOMIC FLUCTUATIONS
14
AS-AD and the Business Cycle
CHAPTER
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Provide a technical definition of recession and
describe the history of the U.S. business cycle.
Define and explain the influences on aggregate
supply.
Define and explain the influences on aggregate
demand.
Explain how fluctuations in aggregate demand and
aggregate supply create the business cycle.
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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• The business cycle is a periodic but irregular
  up-and-down movement in production and jobs.
• A business cycle has two phases, expansion and
  recession, and two turning point, a peak and a
  trough.
• Dating Business-Cycle Turning Points
• The task of identifying and dating business-cycle
  phases and turning points is performed by a
  private research organization, the National
  Bureau of Economic Research (NBER).

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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• To date the business-cycle turning points, the
  NBER needs a definition of recession.
• Recession
• A decrease in real GDP that lasts for at least
  two quarters (six months) or a period of
  significant decline in total output, income,
  employment, and trade, usually lasting from six
  months to a year and marked by widespread
  contractions in many sectors of the economy.

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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• U.S. Business-Cycle History
• The NBER has identified 33 complete cycles
  starting from a trough in December 1854.
• Over all 33 complete cycles
• The average length of an expansion is 35 months
  and the average length of a recession is 18
  months.
• The average time from trough to trough is 53
  months.

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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• So over the 152 years since 1854, the U.S.
  economy has been in
• Recession for about one third of the time
• Expansion for about two thirds of the time.
• The 152-year averages hide significant changes
  that have occurred in the length of a cycle and
  the relative length of the recession and
  expansion phases.

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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• Figure 14.1 summarizes U.S. recession, expansion,
  and cycle length since 1854.

Recessions have shortened.
Expansions have lengthened, and complete cycles
have lengthened.
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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• Recent Cycles
• The last completed cycle began at a trough of
  March 1991 and ended at a trough of November
  2001.
• The economy expanded from March 1991 until March
  2001.
• This expansion, which lasted for 120 months, was
  the longest in U.S. history.

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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• Figure 14.2(a) shows the recent cycles in real
  GDP.

Recessions began in mid-1990 and in first quarter
of 2001.
The longest expansion in U.S. history ran from
the March 1991 to March 2001.
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14.1 BUSINESS-CYCLE DEFINITIONS AND FACTS

• When real GDP decreased in the recession (part a),

The unemployment rate increased (part b).
And a little later, the inflation rate decreased
(part c).
As real GDP increased back toward potential GDP,
the unemployment rate fell toward the natural
unemployment rate and the inflation rate fell.
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14.2 AGGREGATE SUPPLY

• Real GDP depends on the quantities of
• Labor employed
• Capital, human capital, and the state of
  technology
• Land and natural resources
• Entrepreneurial talent

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14.2 AGGREGATE SUPPLY

• At full employment
• The real wage rate makes the quantity of labor
  demanded equal to the quantity of labor supplied.
• Real GDP equals potential GDP.
• Over the business cycle
• The quantity of labor employed fluctuates around
  its full employment level.
• Real GDP fluctuates around potential GDP.

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14.2 AGGREGATE SUPPLY

• Aggregate Supply Basics
• Aggregate supply is the relationship between the
  quantity of real GDP supplied and the price level
  when all other influences on production plans
  remain the same.
• Other things remaining the same,
• When the price level rises, the quantity of real
  GDP supplied increases.
• When the price level falls, the quantity of real
  GDP supplied decreases.

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14.2 AGGREGATE SUPPLY

• Along the aggregate supply curve, the only
  influence on production plans that changes is the
  price level.
• All the other influences on production plans
  remain constant. Among these other influences are
• The money wage rate
• The money prices of other resources
• In contrast, along the potential GDP line, when
  the price level changes the money wage rate
  changes to keep the real wage rate at the
  full-employment level.

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14.2 AGGREGATE SUPPLY

• Figure 14.3 shows the aggregate supply schedule
  and aggregate supply curve.

Each point A to E on the AS curve corresponds to
a row of the schedule.

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14.2 AGGREGATE SUPPLY

• 1. Potential GDP is 10 trillion and when the
  price level is 110, real GDP equals potential GDP.

2. If the price level is above 110, real GDP
exceeds potential GDP.
3. If the price level is below 110, real GDP
exceeds potential GDP.
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14.2 AGGREGATE SUPPLY

• Why the AS Curve Slopes Upward
• When the price level rises and the money wage
  rate is constant, the real wage rate falls and
  employment increases. The quantity of real GDP
  supplied increases.
• When the price level falls and the money wage
  rate is constant, the real wage rate rises and
  employment decreases. The quantity of real GDP
  supplied decreases.

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14.2 AGGREGATE SUPPLY

• Changes in Aggregate Supply
• Aggregate supply changes when any influence on
  production plans other than the price level
  changes.
• In particular, aggregate supply changes when
• Potential GDP changes.
• The money wage rate changes.
• The money prices of other resources change.

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14.2 AGGREGATE SUPPLY

• Changes in Potential GDP
• Anything that changes potential GDP changes
  aggregate supply and shifts the aggregate supply
  curve.
• Figure 14.4 on the next slide illustrates.

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14.2 AGGREGATE SUPPLY
Point C at the intersection of the potential GDP
line and AS curve is an anchor point.
1. An increase in potential GDP shifts the
potential GDP line rightward and ...
2. The aggregate supply curve shifts rightward
from AS0 to AS1.
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14.2 AGGREGATE SUPPLY

• Changes in Money Wages and Other Resource Prices
• A change in the money wage rate or the money
  price of another resource changes aggregate
  supply because it changes firms costs.
• The higher the money wage rate, the higher are
  firms costs and the smaller is the quantity that
  firms are willing to supply at each price level.
• So an increase in the money wage rate decreases
  aggregate supply.

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14.2 AGGREGATE SUPPLY

• Figure 14.5 shows the effect of a change in the
  money wage rate.

A rise in the money wage rate decreases aggregate
supply and the aggregate supply curve shifts
leftward from AS0 to AS2.
A rise in the money wage rate does not change
potential GDP.
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14.3 AGGREGATE DEMAND

• The quantity of real GDP demanded is the total
  amount of final goods and services produced in
  the United States that people, businesses,
  governments, and foreigners plan to buy.
• This quantity is the sum of the real consumption
  expenditure (C), investment (I), government
  expenditure on goods and services (G), and
  exports (X) minus imports (M).
• That is,
• Y C I G X M

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14.3 AGGREGATE DEMAND

• Aggregate Demand Basics
• Aggregate demand is the relationship between the
  quantity of real GDP demanded and the price level
  when all other influences on expenditure plans
  remain the same.

• Other things remaining the same,
• When the price level rises, the quantity of real
  GDP demanded decreases.
• When the price level falls, the quantity of real
  GDP demanded increases.

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14.3 AGGREGATE DEMAND

• Figure 14.6 shows the aggregate demand schedule
  and aggregate demand curve.

Each point A to E on the AD curve corresponds to
a row of the schedule.
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14.3 AGGREGATE DEMAND

• The quantity of real GDP demanded

1. Decreases when the price level rises.
2. Increases when the price level falls.
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14.3 AGGREGATE DEMAND

• The price level influences the quantity of real
  GDP demanded because a change in the price level
  brings changes in
• The buying power of money
• The real interest rate
• The real prices of exports and imports

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14.3 AGGREGATE DEMAND

• The Buying Power of Money
• A rise in the price level lowers the buying power
  of money and decreases the quantity of real GDP
  demanded.
• For example, if the price level rises and other
  things remain the same, a given quantity of money
  will buy less goods and services, so people cut
  their spending.
• So the quantity of real GDP demanded decreases.

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14.3 AGGREGATE DEMAND

• The Real Interest Rate
• When the price level rises, the real interest
  rate rises.
• An increase in the price level increases the
  amount of money that people want to
  holdincreases the demand for money.
• When the demand for money increases, the nominal
  interest rate rises.
• In the short run, the inflation rate doesnt
  change, so a rise in the nominal interest rate
  brings a rise in the real interest rate.

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14.3 AGGREGATE DEMAND

• Faced with a higher real interest rate,
  businesses and people delay plans to buy new
  capital goods and consumer durable goods and cut
  back on spending.
• So the quantity of real GDP demanded decreases.

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14.3 AGGREGATE DEMAND

• The Real Prices of Exports and Imports
• When the U.S. price level rises and other things
  remain the same, the prices in other countries do
  not change.
• So a rise in the U.S. price level makes U.S.-made
  goods and services more expensive relative to
  foreign-made goods and services.
• This change in real prices encourages people to
  spend less on U.S.-made items and more on
  foreign-made items.

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14.3 AGGREGATE DEMAND

• In the long run, when the price level changes by
  more in one country than in other countries, the
  exchange rate changes.
• The exchange rate neutralizes the price level
  change, so this international price effect on
  buying plans is a short-run effect only.
• But the short-run effect is powerful.

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14.3 AGGREGATE DEMAND

• Changes in Aggregate Demand
• A change in any factor that influences
  expenditure plans other than the price level
  brings a change in aggregate demand.
• When aggregate demand increases, the aggregate
  demand curve shifts rightward.
• When aggregate demand decreases, the aggregate
  demand curve shifts leftward.

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14.3 AGGREGATE DEMAND

• The factors that change aggregate demand are
• Expectations about the future
• Fiscal policy and monetary policy
• The state of the world economy

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14.3 AGGREGATE DEMAND

• Expectations
• An increase in expected future income increases
  the amount of consumption goods that people plan
  to buy today and increases aggregate demand.
• An increase in expected future inflation
  increases aggregate demand today because people
  decide to buy more goods and services now before
  their prices rise.
• An increase in expected future profit increases
  the investment that firms plan to undertake today
  and increases aggregate demand.

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14.3 AGGREGATE DEMAND

• Fiscal Policy and Monetary Policy
• Government can influence aggregate demand by
  set-ting and changing taxes, transfer payments,
  and government expenditure on goods and services.
  
• The Federal Reserve can influence aggregate
  demand by changing the quantity of money and the
  interest rate.

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14.3 AGGREGATE DEMAND

• A tax cut or an increase in either transfer
  payments or government expenditure on goods and
  services increases aggregate demand.
• A cut in the interest rate or an increase in the
  quantity of money increases aggregate demand.

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14.3 AGGREGATE DEMAND

• The World Economy
• The foreign exchange rate and foreign income
  influence aggregate demand.
• Foreign exchange rate is the amount of foreign
  currency you can buy with a U.S. dollar.
• Other things remaining the same, a rise in the
  foreign exchange rate decreases aggregate demand.
• An increase in foreign income increases U.S.
  exports and increases U.S. aggregate demand.

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14.3 AGGREGATE DEMAND

• Figure 14.7 shows changes in aggregate demand.

• 1. Aggregate demand increases if
• Expected future income, inflation, or profits
  increase.
• Fiscal policy or monetary policy increase planned
  expenditure.
• The exchange rate falls or foreign income
  increases.

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14.3 AGGREGATE DEMAND

• 2. Aggregate demand decreases if
• Expected future income, inflation, or profits
  decrease.
• Fiscal policy or monetary policy decrease planned
  expenditure.
• The exchange rate rises or foreign income
  decreases.

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14.3 AGGREGATE DEMAND

• The Aggregate Demand Multiplier
• The aggregate demand multiplier is an effect that
  magnifies changes in expenditure plans and brings
  potentially large fluctuations in aggregate
  demand.
• When any influence on aggregate demand changes
  expenditure plans
• The change in expenditure changes income.
• And the change in income induces a change in
  consumption expenditure.

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14.3 AGGREGATE DEMAND

• The increase in aggregate demand is the initial
  increase in expenditure plus the induced increase
  in consumption expenditure.

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14.3 AGGREGATE DEMAND

• Figure 14.8 shows the aggregate demand multiplier.

1. An increase in investment increases aggregate
demand and increases income.
2..The increase in income induces an increase in
consumption expenditure, so
3. Aggregate demand increases by more than the
initial increase in investment.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate supply and aggregate demand determine
  real GDP and the price level.
• Macroeconomic equilibrium occurs when the
  quantity of real GDP demanded equals the quantity
  of real GDP supplied at the point of intersection
  of the AD curve and the AS curve.
• Figure 14.9(a) on the next slide illustrates
  macroeconomic equilibrium.

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14.4 UNDERSTANDING BUSINESS CYCLES
Suppose that the price level is 120 and that real
GDP is 11 trillion, at point E.
The quantity of real GDP demand is less than 11
trillion and firms cannot sell all they produce,
so they cut production and lower prices.
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14.4 UNDERSTANDING BUSINESS CYCLES
Suppose that the price level is 100 and that real
GDP is 9 trillion, at point A.
The quantity of real GDP demand exceeds 9
trillion and firms cannot meet the demand for
their output, so they increase production and
raise prices.
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14.4 UNDERSTANDING BUSINESS CYCLES
Macroeconomic equilibrium occurs when the price
level is 110 and real GDP is 10 trillion.
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14.4 UNDERSTANDING BUSINESS CYCLES
Three possible macroeconomic equilibriums are
1. Below full-employment equilibrium, when
potential GDP exceeds equilibrium real GDP.
2. Full-employment equilibrium, when equilibrium
real GDP equal potential GDP.
3. Above full-employment equilibrium, when
equilibrium real GDP exceeds potential GDP.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate Demand Fluctuations
• Fluctuations in aggregate demand are one of the
  sources of the business cycle.
• To focus on the business cycle, well ignore
  economic growth and inflation and suppose that
  potential GDP and the full-employment price level
  is constant.
• Figure 14.10 in the next slide illustrates the
  business cycle.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Fluctuations in aggregate demand bring
  fluctuations in actual real GDP around potential
  GDP.

In year 1, real GDP equals potential GDP. The
economy is at full employment.

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14.4 UNDERSTANDING BUSINESS CYCLES

• In year 2, at a business cycle peak, real GDP
  exceeds potential GDP. The economy is operating
  at above full employment.

In year 3, real GDP equals potential GDP. The
economy is back at full employment.
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14.4 UNDERSTANDING BUSINESS CYCLES

• In year 4, at a business cycle trough, real GDP
  is below potential GDP. The economy is operating
  at below full employment.

In year 5, real GDP equals potential GDP. The
economy is back at full employment.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Aggregate Supply Fluctuations
• Aggregate supply fluctuates for two types of
  reasons
• Potential GDP grows at an uneven pace.
• The money price of a major resource, such as
  crude oil, might change.
• Stagflation
• A combination of recession (falling real GDP) and
  inflation (rising price level).

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14.4 UNDERSTANDING BUSINESS CYCLES

• Figure 14.11 shows an oil price cycle.

A rise in the price of oil decreases aggregate
supply and shifts the AS curve leftward to AS1.
Real GDP decreases, and the price level rises.
The economy experiences stagflation.
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14.4 UNDERSTANDING BUSINESS CYCLES

• A fall in the price of oil increases aggregate
  supply and shifts the AS curve rightward to AS2.

The price level falls and real GDP increases.
The economy experiences an expansion.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Adjustment Toward Full Employment
• When the economy is away from full employment,
  forces operate to restore full employment.
• Inflationary gap
• A gap that exists when real GDP exceeds potential
  GDP and that brings a rising price level.
• Recessionary gap
• A gap that exists when potential GDP exceeds real
  GDP and that brings a falling price level.

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14.4 UNDERSTANDING BUSINESS CYCLES

• Figure 14.12 shows adjustments toward full
  employment.

Real GDP exceeds potential GDP there is an
inflationary gap and the price level rises.
As the money wage rate gradually rises, aggregate
supply decreases, real GDP decreases, and the
price level rises farther.
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14.4 UNDERSTANDING BUSINESS CYCLES

• Potential GDP exceeds real GDPrecessionary gap
  and the price level falls.

Eventually, the money wage rate starts to fall,
aggregate supply increases, real GDP increases,
and the price level falls farther.
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AS-AD in YOUR Life

• Consider the U.S. economy right now.
• Using the knowledge you have accumulated over the
  course and information you have read in the
  current news, do you think real GDP is currently
  above, below, or at potential GDP?

Talk to your class mates about where they see the
U.S. economy right now. Is there a
consensus? What are the main pressures on AS and
AD right now? Do you think that real GDP will
expand more quickly or more slowly over the
coming months? Will the gap between real GDP and
potential GDP widen or narrow?